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Financial Management · Estimating the cost of capital

Cost of Equity and the Dividend Valuation Model for ACCA FM

Updated 11 October 2026 · Fact-checked

The dividend valuation model says a share's price equals the present value of its future dividends. For constant growth, Ke = D1 ÷ P0 + g, where P0 is the ex-div price. For constant dividends, Ke = D ÷ P0. Estimate g from past dividends or from retained profit times return on equity.

Understand Cost of Equity and the Dividend Valuation Model

Shareholders put money into a company and expect a return. That required return is the cost of equity (Ke). The company must earn at least this much on new projects, or shareholder wealth falls.

The dividend valuation model (DVM) starts from one idea: a share is worth the present value of the dividends it will pay. If you know the price and the expected dividends, you can work backwards to the return investors are demanding.

If the dividend stays the same every year forever, the share is a perpetuity. The price is D ÷ Ke, so Ke = D ÷ P0. If the dividend grows at a constant rate g forever, the price is D1 ÷ (Ke − g), so Ke = D1 ÷ P0 + g. D1 is next year's dividend. The price must be ex-div, meaning the next dividend is not included in it.

The growth rate g can be taken from history. Use the compound growth in past dividends. Or use the Gordon growth model: g = b × r, where b is the proportion of earnings retained and r is the return on those retained funds. Both are estimates, so the DVM gives only an approximate Ke.

Key rules to remember

Constant dividend (no growth)
Ke = D ÷ P0
P0 is the ex-div price. The dividend is the same every year forever.
Dividend valuation model with growth
P0 = D0 × (1 + g) ÷ (Ke − g), so Ke = D0 × (1 + g) ÷ P0 + g
D0 is the dividend just paid. D1 = D0 × (1 + g). P0 must be ex-div. Needs Ke > g.
Growth from past dividends
g = (latest dividend ÷ earliest dividend)^(1 ÷ n) − 1
n is the number of years of growth, which is the number of dividends minus one.
Gordon growth model
g = b × r
b = proportion of earnings retained. r = return on retained funds, often taken as ROE.
Cum-div to ex-div
Ex-div price = cum-div price − dividend about to be paid
Use the ex-div price in the DVM.

How to solve Cost of Equity and the Dividend Valuation Model questions

Use this order for any cost of equity question based on the dividend valuation model.

  1. 1Read the wording. Check whether the share price is ex-div or cum-div, and whether the dividend given is the one just paid (D0) or the next one (D1).
  2. 2If the price is cum-div, subtract the dividend that is about to be paid to get the ex-div price.
  3. 3Decide whether dividends are constant or growing. If constant, use Ke = D ÷ P0.
  4. 4If growing, find g. Use the figure given, or work it out from past dividends, or use g = b × r.
  5. 5Work out D1 = D0 × (1 + g) if you were given D0.
  6. 6Calculate Ke = D1 ÷ P0 + g. Convert to a percentage.
  7. 7Check the answer is sensible and state any assumption, such as constant growth forever.

Quickest way: Three-line DVM calculation

When to use it: Use in Section A and OT case questions where you need Ke from a price and dividends quickly.

  1. Write down P0 (ex-div) and D0. Fix the price first.
  2. Calculate D1 = D0 × (1 + g), then D1 ÷ P0.
  3. Add g and read off Ke. Check the answer is above g.

Common mistakes in Cost of Equity and the Dividend Valuation Model

  • Using D0 instead of D1 in Ke = D1 ÷ P0 + g.

    The question gives the dividend just paid and students plug it straight in.

    Fix: Always ask: is this the dividend just paid? If so, multiply by (1 + g) first.

  • Using a cum-div price without adjusting.

    Students overlook the words cum div in the question.

    Fix: Subtract the dividend due to be paid shortly to get the ex-div price before calculating.

  • Counting the wrong number of years when finding g from past dividends.

    Students use the number of dividends instead of the number of growth periods.

    Fix: Growth periods = number of dividends − 1. Four dividends means n = 3.

  • Using the average of yearly growth rates and not the compound rate.

    It feels simpler, but it is less accurate.

    Fix: Use the nth root of latest ÷ earliest, minus 1, unless the question says otherwise.

  • Using b as the payout ratio in g = b × r.

    Students confuse retention with dividend payout.

    Fix: b is the proportion retained. If payout is 40%, b = 60%.

  • Giving a written answer that ignores model limitations.

    Students focus on the calculation only.

    Fix: Mention the assumptions: constant growth forever, g estimated from the past, no dividend for non-paying firms, and risk not explicitly included.

Worked examples

Example 1

Dalton Co has just paid a dividend of $0.30 per share. Dividends have grown steadily. Four years ago the dividend was $0.22. The current ex-div share price is $4.50. Estimate the cost of equity using the dividend valuation model.

Show the solution
  1. Growth: dividends went from $0.22 to $0.30 over 4 years.
  2. Ratio = 0.30 ÷ 0.22 = 1.3636.
  3. Fourth root of 1.3636: √1.3636 = 1.1677, then √1.1677 = 1.0806. So g ≈ 8.06%, about 8.1%.
  4. D1 = 0.30 × 1.0806 = 0.3242.
  5. D1 ÷ P0 = 0.3242 ÷ 4.50 = 0.0720.
  6. Ke = 0.0720 + 0.0806 = 0.1526.

Answer: Cost of equity is approximately 15.3%.

Example 2

Ravi Co's shares are quoted at $6.00 cum-div. A dividend of $0.40 per share is about to be paid. The company retains 60% of earnings and earns a return of 10% on retained funds. Estimate the cost of equity. Use the model with growth.

Show the solution
  1. Ex-div price = 6.00 − 0.40 = $5.60.
  2. g = b × r = 0.60 × 0.10 = 0.06, or 6%.
  3. The $0.40 is the dividend about to be paid. Once it is paid it is the dividend just paid, so treat it as D0. The ex-div price excludes it, but the next dividend still has to be grown.
  4. D1 = D0 × (1 + g) = 0.40 × 1.06 = $0.424.
  5. D1 ÷ P0 = 0.424 ÷ 5.60 = 0.0757.
  6. Ke = 0.0757 + 0.06 = 0.1357.

Answer: Cost of equity is approximately 13.6%.

Exam tips

  • Circle ex-div or cum-div in the question before you start. Examiners test this often.
  • In OT questions, only one option is right and no partial marks are given, so check D0 versus D1 before you pick.
  • In Section C, show the growth calculation and D1 as separate lines so you earn method marks even if a number slips.
  • When asked to discuss the model, give three or four precise limitations, not a general comment.
  • Cross-check Ke with the CAPM figure if both are given. Large differences are worth commenting on.

Practice questions from Estimating the cost of capital

Cost of Equity and the Dividend Valuation Model in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Equity and the Dividend Valuation Model: frequently asked questions

What is the formula for the cost of equity using the dividend valuation model?

With constant growth, Ke = D0 × (1 + g) ÷ P0 + g, where P0 is the ex-div price. With no growth, Ke = D ÷ P0. D0 is the dividend just paid.

What is the difference between ex-div and cum-div share price?

A cum-div price includes the right to the next dividend. An ex-div price does not. The DVM needs the ex-div price, so subtract the imminent dividend from a cum-div price.

How do I calculate the dividend growth rate in ACCA FM?

Use past dividends: g = (latest ÷ earliest)^(1 ÷ n) − 1. Or use the Gordon model g = b × r, with b the retention rate and r the return on retained funds.

What are the limitations of the dividend valuation model?

It assumes dividends grow at a constant rate forever. Growth is estimated from the past, which may not continue. It is sensitive to small changes in g and does not explicitly reflect risk. It cannot be used directly for companies that pay no dividend.